Sunday, January 27, 2008

More helpless Fed hypothesis

Ilargi: Recently, strictly for entertainment purposes, I wrote a little hypothesis about the Fed’s powers, Just how powerless is the Fed, hypothetically?, based on the following, excellent article by Henry Liu.

I thought I'd allow myself to hypothesize a bit more, strictly for entertainment purposes, as you undoubtedly understand. You see, I was thinking that while Liu is right in his assessment below that the Fed is by no means the only issuer of money and debt, he omits a few important facts nonetheless.

The Fed does have considerable power over money created by banks and other issuers. It can, and does, set reserve requirements for banks, for one thing, which can potentially have a huge impact on the amounts that can be loaned out and created. The Fed also sets the interest rates that dictate how expensive it is to borrow money. And that is not some arbitrary issue; it’s obvious that more people will borrow at 1% than they will at 10%. In the early 1980’s, then Fed Chairman Paul Volcker raised interest rates well into double digits, with the clear intention to stop too much money from being created. And it worked, too, causing a recession in the process.

It was, and is, clear to anyone at the Fed, and beyond, that the opposite would work as well. So when Greenspan lowered US interest rates to 1% from 6.5% in 2001-’03, he knew, and everyone knew, what would happen. People would apply for more credit. And even with the low rates, there was still the potential for constraint through reserve requirements set by the Fed. If anything, they were loosened, not tightened.

Simply imagine what the credit situation would be like today if the Greenspan Fed had followed Volcker’s example... Would mortgages have been handed out to "everyone who could fog a mirror" with interest rates at 10% or higher? Would there have been a $700+ trillion derivatives market without overly cheap and overly abundant credit?

Now I know that there’s people out there, armed with graphs, who postulate that the Fed, when it comes to interest rates, does nothing more than follow the -bond- markets, but that doesn’t satisfy me. If only because the Fed has no obligation to do so. And if they do anyway, we need to ask why.

Coming back to Liu: the advent of the non—bank financial system may have, and certainly has, meant even more money was being created by entities other than the Fed, specifically through the mushrooming derivatives trade, but the Fed didn’t exactly try to stop that process. On the contrary, there are lots of quotes from Greenspan singing the praise of the derivatives market, which according to him almost annihilated all risk in finance:

  • May 2003: “Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management… As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”
  • May 2005: "The use of a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions."
Not that the oracle didn’t cover his derrière:
  • Also May 2005: "The sheer complexity of derivatives instruments, in particular, coupled with the consolidation in the financial industry, made it increasingly hard for regulators and bankers to assess levels of risk."
    "The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress."
So he knew something was amiss, as early as 3 years ago at the latest, but decided not to do anything, claiming he 'believed' markets would solve any and all problems.

To get back again to Liu, yes, it’s true that the Fed is not the sole issuer of money and debt. But no story about that issue is complete if these means of control, which the Fed very much does have, are omitted. It’s a necessary element too for understanding the intention of this week’s rate cut, namely the creation of still more debt and money, something the markets are already drowning in.

The problem these days, however, is that all kinds of parties would like to borrow, and get more liquidity, but lack the collateral, the solvency, to qualify for loans. And that is something that the Fed can indeed not solve: providing liquidity, yes to an extent, but providing solvency, no. They can throw lots of good money after bad, but, starting in 2008, money will disappear faster than they can create it, or push others to do so. Assuming they would want to.

The only effect of all the money-throwing capital infusions we're about to see, and have seen, is to put the American people ever deeper into debt. Ideas about rising inflation can be discarded by now: there's no way the Fed, or any other party, can pump up/in money and debt as fast as it's vanishing through asset devaluation.

And I, for one, find it hypothetically hard to keep on believing that the Fed plays, and has played, an innocent and helpless role in all of this. As I said in a comment yesterday:
"If [you are the owner of the house and] you have all the tools in the house at your disposal, including the cards, the chips, the tables, the bank, the croupiers and the waitresses, and you are the only player in the entire house, and then with all that going for you, you still manage to lose money [to yourself!!] at the end of the day, that's nothing less than redefining incompetence."

And that I find hard to stomach. Hypothetically. The American people have been conned, and all these stimulus packages and bail-outs only serve the purpose of conning them even more, and longer. Yes, for entertainment purposes only.

Here's the part of the article I was commenting on:

Fed helpless in its own crisis
As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nation’s money supply. While the Federal Reserve commands a monopoly on the issuance of the nation's currency in the form of Federal Reserve notes, which are "legal tender for all debts public and private", it does not command a monopoly on the creation of money in the economy.

The Fed does, however, control the supply of "high power money" in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks to create money by lending the same money to customers multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers.

But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth.

As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency.

Now, even though I’ve been poking at Liu a little with regards to the 'helpless' Fed, I hope it’s still clear that he is, as I’ve said before, one of my favorite finance writers. So here’s a few more gems from the same article:

On a Stimulus Package:
... the Republican proposal favors a tax rebate, meaning that only those who actually paid taxes would get a refund. That means a family of four with an annual income of $24,000 would receive nothing and only those with annual income of over $100,000 would get the full $800 rebate per taxpayer, or $1,600 for joint return households.

Further, against a total US consumer debt (which includes installment debt, but not home mortgage debt) of $2.46 trillion in June 2007, which came to $19,220 per tax payer, the Bush rebate of $800 would not be much relief even in the short term. In 2007, US households owed an average of $112,043 for mortgages, car loans, credit cards and all other debt combined. Outstanding credit default swaps is around $45 trillion, which is three times larger than US GDP of $15 trillion and 3,000 times larger than the Bush relief plan of $150 billion.

On Bond Insurers and Credit Default Swaps:
For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along with the premium they charge. There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, an investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.

Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co valuation model. Contracts on Ambac Financial, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac's implied chance of default is 73%.


The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2.4 trillion of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers - a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital. Significant changes in counterparty strengths of bond insurers could lead to systemic issues.[..]

If credit insurers turn out to have inadequate reserves, the credit default swap (CDS) market may well seize up the same way the commercial paper market did in August 2007. The $45 trillion of outstanding CDS is about five times the $9 trillion US national debt.

The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis.

The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: "What [worries me] is if one of these entities doesn't make it ...? The secondary effect ...? I think could be pretty terrible."

On Corporate Bonds and Commercial Real Estate:
As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.


TenThousandMileMargin said...

Following yesterday's comments on the role education played in getting us into this mess:

At high school, I studied English, Maths,Chemistry,Physics,Music and History.

Funnily enough I don't recall a subject called "Scams and Swindles" or "Money and How to Keep it". Such subjects weren't offered.

English and Maths were compulsory because apparently everyone needs to know how to read and do differential equations.

But what we really need are subjects that teach you how not to screw your life up. How to avoid being a patsie.

The curriculum should include famous scams of the past - the South Sea Bubble, the Tulip bubble, the original Ponzi scheme, the 1929 bubble. Then move on to cover lotteries, casinos, loan sharking operations, Nigerian letters and MLM. Explain the power of compund interest and how it works against you. Explain bracket creep and inflation as forms of hidden taxation. Explain deficits, lobbyists and campaign financing.
A few cautionary words about divorce and child support wouldn't go astray either.
History should focus on dictators, tyrants, predators of various kinds, the way they came to power and their abuse of it.

But the message we actually get is that money isn't really important, you should focus on having fun, job satisfaction, the arts and sciences, getting along and being a good person.

Don't think about the levers of power and all the ways you can get stitched up. It might make you reluctant to buy a new car on credit.

Anonymous said...

Great work, ilargi. Are you watching the Asian market tonight? Down about 385 so far.

cowpoke said...

Just want you guys to know I am a lurker and thank you very much for your hard work. Can you tell if you are getting much traffic through some sort of blogspot control panel?

Greyzone said...

Asia as I prepare to head to bed:

Shanghai Composite 4,449.59 1:38AM ET Down 312.10 (6.55%)
Hang Seng 23,791.95 1:54AM ET Down 1,330.42 (5.30%)
BSE 30 17,548.41 1:54AM ET Down 813.25 (4.43%)
Jakarta Composite 2,562.73 2:09AM ET Down 57.77 (2.20%)
Nikkei 225 13,087.91 1:00AM ET Down 541.25 (3.97%)
NZSE 50 3,710.32 Jan 27 Down 18.83 (0.50%)
Straits Times 3,018.81 6:09PM ET Down 140.67 (4.45%)
Seoul Composite 1,627.19 1:02AM ET Down 65.22 (3.85%)
Taiwan Weighted 7,485.79 12:46AM ET Down 253.80 (3.28%)

Asia is resuming the free fall we saw last week and which was briefly interrupted by the fall guy story about the rogue trader (which clearly the rest of the world has decided not to believe at this point).

OuttaControl said...

I guess I'm not convinced either way as to how much power the Fed really has and how much of that power is fundamental liquidity injection and how much is purely psychological. What I think I know is this; they've blown through about a third of whatever ammunition they might have with the federal funds rate. And it seems as though these rate decreases are met with ever diminishing effects, at least in terms of stock market levels. There may well come a 'tipping point', as much as I hate to use that cliche, when lowering rates further will actually accelerate the sell-off.

This whole mess is way too much for this newbie web-based economics student to come to terms with. It was just a year ago that my main concern was peak oil. Hah! I long for those days. Actually, dealing with the reality of peak oil probably prepared me for trying to deal with a deflationary depression. TTMM couldn't be more right about the failures of our education system. On the other hand, I don't think I would trust a government agency to get the details right. I guess that's why lots of people home-school their kids. For me, I just make sure my kids' extra-curricular education conforms to a different standard.

Anyway, I can't thank you guys enough for this information. It could proave to be a defining moment in my life and, I'm sure, others.

PS: Where's Stoneleigh these days?

Stoneleigh said...

I'm here, but I'm not as prolific as ilargi. He's a high energy individual who's hard to keep up with :)

I definitely agree with ilargi on the failures of the education system (by which I mean the curriculum, not the people who deliver it). I've often had to redress economic propaganda masquerading as fact in my children's textbooks.

Where Ilargi and I differ is on the matter of the Fed's power. To me, the Fed choses an interest rate to defend following the bond market (the formidable power of the international collective). I would say the Fed has little ammunition left as interest rates are very low and reserve requirements have already been reduced virtually to zero. The nominal rate can't go below zero, which would still leave the real rate (adjusted for positive or negative inflation) punishingly high during a contraction of the money supply. Good luck to the Fed trying to convince people to borrow and lend in order to inflate the money supply under those circumstances.

IMO long term rates set by the market won't follow the downward trend in short term rates set by the Fed (following the market). I also think mortgage rates will decouple from 10 year bond rates and end up very high indeed compared to what people are used to.

Unfortunately, high rates in nominal terms means rates going through the roof in real terms, which would put many homeowners deep in trouble - negative equity as prices fall, liquidity disappearing in the ultimate buyers market, a skyhigh interest rate on a house no one wants to buy, and potentially the calling in of loans to top it all off. This is why I don't think it's safe to carry even a relatively small mortgage. Debt is a killer in a deflation, and cash is king.

CrystalRadio said...

Illargi, thanks for writing so clearly about a subject that has become such a necessity to understand. I am, thanks to you both, now finding it quite interesting despite it's ominous implications.

One thing I would like understand more clearly, as most of the news in all this is necessarily dominated by the US, is a clearer idea of how Canada will be affected in aspect, timing and degree. Any direction here would be most appreciated as I have people to convince that we will be for the high jump as well, despite our wealth in resources like oil gas and even that plum potash.

Thanks for all the work you two have been doing, it is much appreciated.

MonkeyMind said...

If I am correct in assuming that the 'big players,' those that command billions of bucks, have vastly superior information re: money, then the recent Gulf of Tonkin, er, Hormuz incident slots into my tinfoil hat scenario nicely. A war would have hidden the economic wreckage nicely.

Thanks for the Automatic Earth!

lz said...

ilargi et al,

now you get us hooked in this entertainment, please don't let us hanging here without revealing the whole plot. we saw the pump-dump so far, but what will be the end game?

thanks for such interesting entertainment at such interesting time.

Stoneleigh said...

Hi Crystal Radio,

IMO Canada is beginning to feel the pinch, but is still lagging behind the US. There was a headline in my local paper the other day wondering if the sudden slowdown in the real estate market might be a result of bad weather last month. Talk about being completely unaware of what's going on in the rest of the world!

Our branch plant economy in eastern Canada will be devastated by a fall in US demand, especially for cars. In the west, the forestry industry will end up feeling the lack of demand for home-building soon enough, especially when Vancouver's phenomenal housing bubble really bursts. The Alberta energy complex is also likely to take a big hit as deflationary demand destruction reduces energy prices (temporarily, but probably for long enough to kill off many projects).

Although the excesses of the mania were less of a factor in Canada, we still have a huge debt problem - personal, corporate and public. Although we had little lending that could be called subprime, we've still had a huge amount of lending to people who won't be able to make their monthly payments if long term interest rates rise (as I think they will). We've seen 40-year mortgages, which are characteristic of extreme economic complacency.

Our federal government has been running budget surpluses, but still has an outstanding national debt of over $500 billion. The feds have downloaded responsibilities to the provinces and the provinces have downloaded them to municipalities, which are now in crisis in many places.

Downloading responsibilities doesn't necessarily come with downloading the funding to cover them by any means. Municipalities suddenly find themselves with responsibility for infrastructure maintenance, for instance, without the teams of professionals the province used to employ or the means to pay for them. Municipal governments find it hard to raise property taxes to cover persistent shortfalls, so maintenance is delayed and service cuts are implemented, but taxes must still go up.

Of course the looming financial upheaval is likely to send many of these issues critical over a relatively short time horizon.

Anonymous said...

Great read ilargi. Stumbled over hear from the Oil Drum and here to stay. Thanks very much for all your work.

One thing i can't get away from is the sinking feeling that all this stimulus is akin to throwing more gas on a fire. Sure its wet, but ...

CrystalRadio said...

Thanks Stoneleigh for the backup, several people here in lotus land need a bit of a waking up and I don't have the background to ring that bell.

I did find this today about Canada from Merrill Lynch:

RPT-Bay Street Week Ahead-Darker clouds dot the horizon (Reuters)

But some forecasters, including David Wolf, chief Canadian economist at Merrill Lynch, have said that they believe the United States is already in a recession and that darker days are ahead for stocks.

Wolf has cut his 2008 forecast for Canadian stocks, predicting the worst yearly performance since 1990.

"We revised down our S&P TSX composite target to 11,300 at end-2008 and 12,500 at end-2009... The risk is that the trough in 2008 may be below the 10,000 mark." Continued...
Do links work, I had trouble with posting the URL for the article, but I imagine a google search with the title should get it. There is more that is quite good and I think worth reading.
Also saw a Dannielle Park from Venebale Park (investment co in Barrie Ont.)on a CBC business report do a bit of jumping up and down about the other stock investment guru's giving out the 'Buy and hold' advise. Quite refreshing to see.

Yes the lumbermen are already beginning to lurch and stumble out of the woods here and yet it seems just the beginning of that problem.

Other than that, not too much realistic Canadian news to be seen, considering the events unfolding.